Fixed-Charges Coverage Ratio in QuickBooks 2013

The fixed-charges coverageratio is one of several leverage ratios can be used in QuickBooks 2013. The fixed-charges coverage ratio resembles the times interest earned ratio. The fixed-charges coverage ratio calculates how easily a firm pays not only its interest expenses, but also any principal payments on loans and any other obligations for which a firm is legally obligated to pay.

The fixed-charges coverage ratio uses the following formula:

income available for fixed charges/fixed charges

Check out the balance sheet shown and the income statement shown.

A Simple Balance Sheet

Assets

Cash

$25,000

Inventory

25,000

Current assets

$50,000

Fixed assets (net)

270,000

Total assets

$320,000

Liabilities

Accounts payable

$20,000

Loan payable

100,000

Owner’s equity

S. Nelson, capital

200,000

Total liabilities and owner’s equity

$320,000

A Simple Income Statement

Sales revenue

$150,000

Less: Cost of goods sold

30,000

Gross margin

$120,000

Rent

5,000

Wages

50,000

Supplies

5,000

Total operating expenses

60,000

Operating income

60,000

Interest expense

(10,000)

Net income

$50,000

Suppose that the $5,000 of rent shown in the income statement is actually a fixed charge because the firm is renting space on a long-term lease. Further suppose that for the purpose of this ratio, although it doesn’t show up on the income statement, the $100,000 loan that shows up on the balance sheet requires an annual $5,000 in principal payments.

In this case, this firm is obligated to pay fixed charges as summarized. In total, then, fixed charges for this firm equal $20,000 a year.

Fixed-Charges Calculation

Interest

$10,000

Rent

5,000

Principal

5,000

Fixed charges

$20,000

The other input needed to calculate the fixed-charges coverage ratio is the income available for these fixed charges. The following shows you how to calculate the income available for fixed charges.

Income Available for Fixed Charges

Operating income

$60,000

Add-back of rent

5,000

Fixed charges

$65,000

You start with the operating income, which equals $60,000. (Remember that the operating income is the income before paying interest expense.) You must add to the operating income any fixed charges included in the income statement.

In this case, the rent turns out to be a fixed charge. Therefore, the $5,000 of rent needs to be added to the operating income in order to get income available for fixed charges. The income available for fixed charges equals $65,000.

With the two needed inputs, you can calculate the fixed-charges coverage ratio by using this formula:

$65,000/$20,000

This formula returns a fixed-charges coverage ratio of 3.25, which indicates that the firm generates slightly more than three times as much income as needed to pay its fixed charges.

No guideline exists to specify what your fixed-charges coverage ratio should be. In fact, it is particularly difficult to get the information necessary to think about fixed-charge coverage ratios because fixed charges don’t clearly appear in the standard set of simple financial statements.

One of the things that make financial statements (that are prepared in accordance with generally accepted accounting principles) so useful is that the fixed-charges information is usually disclosed in little footnotes that appear at the end of the financial statements.